We Are Witnessing the Stock Market Do Something for Only the 2nd Time in 155 Years, and History Is Clear About What Comes Next
The S&P 500 (SNPINDEX: ^GSPC) is still up about 12% this year, but the ride for investors has gotten a bit rougher lately. After setting a record earlier this month, the index has fallen nearly 2% as sticky inflation and rising bond yields spook investors.
And the tech-heavy Nasdaq Composite (NASDAQINDEX: ^IXIC) took an even bigger hit, dropping more than 4% from its high. Those rising yields hit high-growth tech stocks — especially those that are tapping debt markets more and more — harder. The sustainability of the artificial intelligence spending boom is keeping Wall Street on edge, especially given that stocks are very expensive by historical standards.
Missed Nvidia in 2009? This Rare Signal Is Flashing Again. In 2009, a “Double Down” signal flashed for a little-known chipmaker called Nvidia. For the first time in years, that same “Total Conviction” signal is flashing for a company 1/100th the size of Nvidia. Continue »
The Shiller CAPE ratio, one of the most widely followed measures of stock market valuation, has now been floating above 40 for a few months. That’s only happened once before in 155 years of stock market data: during the peak of the dot-com bubble.
That’s not exactly a comparison that inspires confidence.
What the CAPE ratio tells us
Short for cyclically adjusted price-to-earnings ratio, the CAPE compares the S&P 500’s price with its average (inflation-adjusted) earnings over the previous 10 years. While a simple P/E ratio can make stocks look unusually cheap or expensive depending on whether businesses just had a great year or a terrible one, zooming out to a decade average removes the noise and helps give a clearer picture of what’s actually going on.
The CAPE’s long-term average is roughly 17.4. Today’s reading is well over twice that. Its all-time high came in December 1999, when it reached 44.2. A few months later, the dot-com bubble burst, and the stock market began its precipitous decline, eventually losing nearly half of its value.
Check out the CAPE over time in the chart below.
Shiller CAPE Ratio data by YCharts
Buffett’s valuation warning
The CAPE isn’t the only metric reaching worrying levels. Looking at the value of the U.S. stock market versus the gross domestic product (GDP) of the U.S., a measure popularized by investing legend Warren Buffett, we can see that things are looking pricey. Today, it stands at around 244%. In other words, stocks are worth more than twice what the U.S. economy produces in a year.
In the aftermath of the dot-com bubble, when the indicator had reached as high as 190%, Buffett famously told investors that when the ratio approaches 200%, “you are playing with fire.”
